Millions of people and some institutions have gold they can sell and buy back via futures contracts; when they choose not to, that's the beginning of the end of the current financial system.

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Professor Antal Fekete has written several pieces discussing gold backwardation, and arguing that this is the red alert signal for the coming financial Armageddon, when the tower of unpayable debts collapses. In this paper, I delve deeper into this topic. My goal is to make this topic approachable for the layman and describe what I think will happen when backwardation in gold futures becomes permanent.

Most people define "backwardation" for a commodity as the occasion when the price of a future contract is lower than the price in the spot market. But since there are two prices for everything, we must look at the bid and the offer. They are more meaningful than the last cleared price (which is what people think of as "the price"). So we must refine the concept of backwardation slightly, as I will show below.

In backwardation, one can sell a physical good for cash and simultaneously buy a future to make a profit. Note that in doing this trade, one's position does not change in the end. One begins with a certain amount of the good and ends (upon maturity of the contract) with that amount of the good.So let us examine the actual trade that any arbitrager in the market could do. To sell the physical commodity, one must take the bid. And likewise, to buy the future one must pay the offer. With this arbitrage in mind, we define the term:

Backwardation is when the bid in the spot market > offer on a future.

Why is this important? What does it mean?

Many commodities, like wheat, are produced seasonally. But consumption is much more evenly spread around the year. Immediately prior to the harvest, the spot price of wheat is normally at its highest. This is because wheat stocks in the warehouses are very low. People will have to pay a higher price for immediate delivery. At the same time, everyone in the market knows that the harvest will be in one month. So the price, if a buyer can wait one month for delivery, is lower. This is a case of backwardation.

Normally, backwardation is a signal that a commodity is scarce. This is because if anyone had a quantity of it, they could make a risk-free profit by delivering it and getting it back later. Markets do not normally offer risk-free profits, and in the case of backwardation there's not normally a real opportunity to make a risk-free profit because the good really is scarce -- no one has a lot of it to sell at that time.

It's worth delving into arbitrage briefly to complete the point about backwardation. Arbitrage is, in essence, an attempt to make a profit on a spread (usually by buying one thing and selling another). The important thing to note is that the arbitrager pays the offer on what he buys, thus lifting said offer, and takes the bid on what he sells, thus depressing said bid. The arbitrager, alone or with many others doing the same trade, will usually force the spread to narrow to the point where further arbitrage is no longer profitable. If it is possible to make a risk-free profit someone will do it, and another, and so on until it is no longer feasible to make a risk-free profit.

I said "usually" because in the case of a shortage of wheat it's not possible to make a risk-free profit unless one has physical wheat in one's warehouse. In the case when there's not enough grain remaining in stock to compress this spread, backwardation persists (or grows) until the harvest.

Earlier, I said backwardation "normally" means there's a shortage. But what if backwardation happens to gold? There is more gold in human possession than any other commodity by a factor of 100 or more (abundance or scarcity must be measured as a ratio of stocks or inventories to flows or annual production; the absolute amount is not important). Given gold's massive accumulated inventories, a "shortage" of gold is impossible.

So what does gold backwardation really mean?

For ordinary commodities, the lower price on the future contract vs. spot signals the relative scarcity available for delivery today vs. delivery in the future. But what would a lower price on gold for future delivery mean compared to a higher price on gold to be had in one's hand today? Well, mechanically, it means that gold delivered to the market is in short supply.

The meaning of gold backwardation is that trust in future delivery is scarce, vs. trust in the gold in one's hands today.

In an ordinary commodity, scarcity of the physical good available for delivery today is resolved by higher prices. At a high enough price, demand for wheat falls until existing stocks are sufficient to meet the reduced demand.

But how is scarcity of trust resolved?

Thus far, the answer has been via higher prices. However, when backwardation becomes permanent, then trust in the gold futures market will have collapsed. Unlike with wheat, millions of people and some large institutions have plenty of gold they can sell in the physical market and buy back via futures contracts. When they choose not to, that is the beginning of the end of the current financial system.

Why?

Think about the similarities between the following three statements:

"My paper gold future contract will be honored by delivery of gold."

"If I trade my gold for paper now, I will be able to get gold back in the future."

"I will be able to exchange paper money for gold in the future."

I submit that it will not take gold holders a long time to arrive at the inevitable conclusion. If some holders of gold do not agree, then they will sell (at higher prices, probably) to those who do. Soon enough, there will not be sellers of gold in the physical market.

With an ordinary commodity, there's a limit to what buyers are willing to pay based on the need satisfied by that commodity, the availability of substitutes, and the buyers' other needs that also must be satisfied within the same budget. The higher the price, the more that holders are motivated to sell and the less that consumers are motivated (or able) to buy. The cure for high prices is high prices.

But gold is different. Unlike wheat, it's not bought for consumption. While some people hold it to speculate on increases in its paper price, by the logic above, they will be replaced by people who are holding it because they do not trust paper and want to hold gold because gold is money.

Gold does not have a "high enough" price that will discourage buying or encourage selling. No amount of price change will bring back trust in paper currencies once said currencies decline past the threshold where it is obvious to a critical mass of people. Thus gold backwardation will not only recur, but at some (hard to predict) point, it will not leave its backwardated state.

In looking at the bid and offer, one other fact is germane to this discussion. In times of crisis, it's always the big that is withdrawn; there is never a lack of offers. Another way of looking at permanent gold backwardation is as the withdrawal of gold's (i.e. money's) bid on irredeemable government debt paper (e.g. dollar bills). But paper's bid on gold is unlimited.

The remainder of this essay addresses what will happen to non-monetary goods when gold goes into permanent backwardation. Note that it's possible that silver will go into backwardation prior to, concurrently with, or following gold. I make no prediction about the sequence. In the following discussion, everything should be interpreted to apply to silver as well as gold.

Many people who hold paper but who desire to hold gold will buy, for example, crude oil for paper, and then sell it for gold (I will call buying a commodity for paper to sell it for gold "gold arbitrage"). This will drive up the price of crude in terms of paper, and drive down the price of crude in terms of gold. Even if this "window" were to remain open indefinitely, it is obvious that larger and larger amounts of paper will buy dwindling amounts of gold. This is because of the twin rising prices of crude-in-paper and gold-in-crude.

For example, if today the price of a barrel of crude in terms of paper is $100, and gold priced in crude is 15 barrels, then $1,500 can be traded for one ounce of gold this way. But if the price of crude in paper rises to $2,000 and the price of gold in crude rises to 150 barrels, then one would need $300,000 to trade for one ounce of gold this way. There will always be a gold bid on crude, but it need not necessarily be high.

Of course, this window will shut sooner or later (I suspect sooner), as I show below.

To summarize, what I have outlined above is the logical outcome of permanent gold backwardation. With an understanding of Austrian economics, particularly the ideas of Carl Menger and Antal Fekete, one can see that in permanent gold backwardation the following steps are inevitable:

Withdrawal of offers to sell physical gold for paper money

Skyrocketing price of liquid commodities in terms of paper

Falling price of commodities in terms of gold

Gold is not officially recognized as the foundation of the financial system. Yet it is still a necessary component, without which the system will collapse. As I will show, it is impossible to divorce gold and paper without also divorcing commodities and paper.

Earlier, I gave three equivalent statements:

"My paper gold future contract will be honored by delivery of gold."

"If I trade my gold for paper now, I will be able to get gold back in the future."

"I will be able to exchange paper money for gold in the future."

My point was to show that these statements are all false. They're false for the same reason. This is what's discovered by the market, when it goes into permanent backwardation. Paper currencies are backed by debt, and the debt has grown far past the point where it could possibly be repaid. It's rapidly approaching the point where the interest cannot be kept current. So governments and other borrowers seek to borrow ever more money to pay the interest on their debt and to cover their permanent deficits. This cannot continue forever, or indeed much longer.

There's a fourth statement that's equivalent to the other three above:

"My paper money will be accepted in trade for the goods I need in the future"

If the first three are false, this one is also necessarily false.

The commodity producers will eventually be forced to do business by buying their inputs for gold and selling their outputs for gold. To validate this, let's use the technique of assuming the opposite is true, and see if that leads to a contradiction. Let's assume that commodity producers will continue to operate by buying their inputs for paper and selling their outputs for paper. As discussed above, paper prices for their output products will be skyrocketing. At first, this would seem to be good for them.

However, we must consider that each business needs to keep the appropriate balance of its capital in cash, ready to pay for inputs, wages, etc. Under conditions of rapidly rising prices for inputs, cash is rapidly losing purchasing power. One cannot keep cash for more than a day (if that), without losing precious capital. Every business will spend its cash as quickly as possible. Now someone has to hold it, as the cash does not go out of existence when one spends it -- it just goes into someone else's hands. So this will be a period of rapidly accelerating capital decumulation. Second, most businesses will have a suboptimal allocation of cash which is determined, not by rational analysis, but by this game of "hot potato." This leads to another consequence: shortages.

Ordinarily, the businessman does not want to keep excess inventory of his output product. This is because the marginal utility of oil or tires or whatever declines rapidly, but the marginal utility of money (even paper money) does not. But in the condition of gold backwardation, the marginal utility of paper is declining faster than any real product.

So the commodity producer would be wise to keep its output in inventory, and only sell his products as he needs the cash to buy another input. This is inefficient, and tantamount to losing the benefit of indirect trade. It will cause supply disruptions to businesses that use this commodity as their input. It will also cause much wider spreads, as the market becomes less liquid, and rapidly changing prices add the risk that a normally profitable spread could become unprofitable. Narrow spreads are a sign of increasing economic coordination; widening spreads are a sign of collapsing coordination.

In gold backwardation, the next problem for commodity producers to (somehow) address is: how can a business use a rapidly diminishing currency as its unit of account? How is one to even determine whether production is profitable or unprofitable? Hint: if a business is decumulating capital, it's making losses.

One must also consider real demand (as opposed to the demand for a medium for the gold arbitragers). As the paper price rises, most buyers don't have unlimited amounts of paper to pay. How many people can fill their car with gasoline every week at $100 per gallon? How about $1,000? Real demand for commodities is collapsing in this environment (going back to the analysis above, recall that the prices of commodities in gold are falling). But the prices are rising in paper terms. Regardless of the value of paper money, in real terms: most businesses that produce a good with rapidly falling demand do not make a profit.

Another challenge comes from the fact that not all prices rise equally. As discussed above, the primary driver for liquid commodity prices is the arbitrage to get into gold, because there will always be a gold bid for food and energy. But what about specialty manufactured products?

Machine parts and truck tires do not make a suitable vehicle for the gold arbitrage, and so their prices may not rise to the extent of oil and wheat. The spread (profit margin) for manufacturers of these items, who need to buy oil as their inputs, may very well become permanently negative. While there will be some demand from commodity producers to provide a bid, such thinly traded markets could see enormous volatility. The nature of a business who makes a specialty product for a thinly traded market, especially a business which is thinly capitalized, is that it must make a profit every month or at least every quarter or else close its doors. Even if the spread reverts to the mean, an inversion lasting one or two months could be enough to destroy such a company.

And even if the spread does not collapse, think of the behavior of their customers. Unlike oil drillers whose output product is in constant demand (especially by the gold arbitragers), who can choose exactly when they sell their products, specialty manufacturers are not sovereign. They must sell when buyers want to buy. But their buyers, the commodity producers, are going to be controlling their buying and selling in larger batches rather than the steady buying of "just in time" that was operative when the currency was stable.

So here's a summary of (some) consequences suffered by all commodity producers who try to do business in terms of paper money after permanent gold backwardation:

Capital decumulation due to the necessity of holding some cash at some times while said cash is rapidly falling in value

Supply shortages, including failure of critical vendors, causing production disruptions and lost time/money

Hoarding of produced goods

Collapsing real demand

Skyrocketing prices do not perfectly compensate for skyrocketing costs

Rising volatility and widening spreads across the board

No usable unit of account for one's books, so losses will (temporarily) look like gains

As currency devolves, efficiency of transactions devolves also to become more like direct (barter) trade, requiring coincidence of wants or at least timing

Without even addressing strikes by workers, failure of critical infrastructure like the electrical grid, or the breakdown of law and order (how will the government collect and use taxes to employ police and firefighters?), it should be clear that businesses who use paper money will not be able to operate profitably for long.

Thus it's safe to conclude that the gold miners will not continue to provide gold to the paper market. The same holds true for all other commodities. By temporarily assuming that commodity producers could continue to supply goods to sell for paper, the opposite has been proven.

While no one can predict the timing, and I think that it will be years away, my conclusion is that Von Mises' "Crack Up Boom" is an inevitable consequence of permanent gold backwardation.

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